Corporate Optimal Capital

Structure (OCS):

The Dirty
Dozen?
OPTIMAL CAPITAL STRUCTURE involves the pursuit of
‘best’ (note the quotation marks) mix of debt and equity.

As such, the CFO/FD’s selected OCS approach impacts upon the firms:

Overall cost of financing (WACC) and future availability of financing

Market perceptions of under- or over-gearing, sometimes

combined with debt-servicing and debt-default concerns

Hurdle-rate for internal investment decisions

AOTBE, the worth of the company.

. HOW?

WHY?

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Note that:

Conventional OCS (mis?)practice per many finance textbooks is to

emphasise just two or possibly three methods over all the many other
alternatives methods actively applied by corporations today, instead

The broad range of different OCS perspectives and approaches as

reflected in this week’s assigned readings should suggest to you that
overly narrow OCS approaches are inconsistent with how finance is
actually conducted in the real world.

In addition, in some instances, some outright errors persist in some of the

descriptions of OCS tactics in even (otherwise) highly regarded finance
texts, e.g., misdiagnosis of cash and thus retained earnings as costing
nothing, use of effective rather than nominal tax rates.
.

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 NO ‘One Size Fits All’

There is no single, universally

applied ‘correct’ OCS approach
that works for each and every
corporation’s situation and
requirements. In fact, in some
circumstances, combination
approaches make the most
sense: either as two parts of the
same coordinated OCS strategy,
or alternatively, with one
approach serving as contingent
back-up to the first.

There is only the best single or combination approach given that particular firm’s salient
circumstances & requirements, now and into the future, including but not limited to: (1)
need for investible funds, (2) whether or not the company is dangerously over-geared,
(3) any requirement for high levels of extra cash (liquidity requirements), (4) safety-
security needs…. OTHERS? 4
 ??????????
UNDER WHAT CIRCUMSTANCES DOES
THE SELECTED APPROACH(ES)
REPRESENT THE MOST DEFENSIBLE
OCS APPROACH CORRESPONDING
TO THAT FINANCING-RELATED
OBJECTIVE?

5
 1L TARGET GEARING

•  Company management has a preconception about what is a ‘good’ gearing* aka

leverage ratio: industry comparable (particularly leader). Research analysts
prescriptions? Overall average? (US= 78%) CEO’s inclination? (Eastman= 5%)

•  ISSUES include:

(1) Obviously, the suitability of that particular D/C ratio for that firm: Peloton and LTCM chose
30: 1 debt-to-equity ratios, and that contributed to the destruction of both firms; George
Eastman destroyed value for other shareholders in Kodak with his under-geared approach

(2) Some of the OCS thought leaders (papers) question whether companies ‘move towards’
their target, or rather, just add financing on an opportunistic basis and monitor the resulting

•  Suitability for consideration for your corporation?

Variable, dependent on the defensibility of the target chosen, and the quality of the
analysis underlying that choice

L denotes one of the legacy approaches frequently arising in conventional finance texts

* Long Term Debt (LTD, numerator) divided by Capital (denominator) here defined as sum of LTD plus total 6
Owners’ Equity: common & preferred stock, paid-in-capital, retained earnings NOTE ST DEBT EXCLUDED
2L CHEAPEST FINANCING AVAILABLE Relative cost of
component financing
@ specific company
(Pecking Order)
LOW
a few examples:
•  Company considers LT financing as a continuum (right)
with after-tax cost generally increasing with progression from
senior secured debt (cheapest) to emergency common equity, Subordinated
senior debt
or rights offers (UK) the dearest… WHY? (unsecured)

•  Issues include:
Corporate paper
(’corporate
(1) Correcting the retained earnings error in McLaney and IOUs’)
-to-
papers Debt-equity
hybrids
(2) Short-termism? If used exclusively, is there an inevitable
result of over-gearing, followed by collapse in credit-
worthiness (and then, extremely HIGH costs, presuming that
financing is available at all) Preferred stock

•  Suitability your corporation?

Modestly geared companies, management prone towards instinctive

HIGH
(impulsive) approaches to OCS, rather than strategic.
7
3 FUNDS AVAILABILITY (or, What Can We Get Our Hands on the
Easiest, Fastest)
•  Q: What is the likely financial condition of a company that just wants the cash and doesn’t
ask the cost (Hint: Doorstep lenders such as Wonga.com charge over 1,400% APR!)

•  Inside / Out: Starts with retained earnings (most expensive), the liquidating major asset
groups that are easiest to sell at a discount. External financing takes too long, requires
up-front fees

•  Issues include:

(1) Signal to other capital providers, The City / Wall Street of firm’s imminent demise? Circuit
City, Zavvi, Woolworths, Madoff. May cause stampede, plunging company into insolvency

(2) Increased financial + operational risk, caused by reduction of financial reserves

•  Suitability for your corporation?

OK on a spot basis if firm has excess cash + near cash. Likely to be (accurately) perceived as
the last available financing for an imploding company, otherwise. Emergency use only: this
company can’t even survive for a rights offering!
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 4 LEVERAGING UP NEW EQUITY ADDITIONS

•  Calls for firms to adopt a Post-IPO*- like perspective and approach to its overall financing:
OK, so we we just obtained this huge amount of foundation equity financing… SO, how many
times with Wall Street or The City let us gear up (multiply) this base financing before our credit
rating suffers significantly?

•  Issues include:

(1) Only for recent IPOs, or can it effectively be utilised by more-established companies, as well?
(e.g., through units offerings?– see banks’ CoCos)

(2) ‘Start point’ is equity, highest cost financing: cost / timing / availability issues.

(3) Getting the gear-up multiple right: Q: Why might existing senior lenders resist ‘gearing-up’ to
the maximum amount, even if there is precedent?

•  Suitability for corporation?

Takes a financial team that (1) thinks strategically rather than reactively, (2) can easily time its
‘foundation’ equity to the most advantageous time (See 9). For some, sounds good in theory,
difficult to implement. Resistance from entrenched capital providers?
9
* Initial Public Offering: Company’s first major common stock offering, transition from private to public ownership.
5L VALUE OF DEBT TAX COVER v PV OF BANKRUPTCY
CAUSED BY DEFAULT ON DEBT (static tradeoff)
•  Classical approach to Optimal Capital Structure, as evidence by several of the thought
leaders in this field. A benefit-versus-(risk adjusted) cost approach which may (a.) be better
suited to assessment of individual parcels of added debt as contrasted with strategic OCS
design, (b.) myopic: looks only at debt, in isolation

•  Issues include:

(1) Whether practical FDs are inclined to use what is essentially an scholarly (academic) approach,
say, compared to target D/C (No. 1). In the papers, some anguish over separating tax cover
attributable solely to tax cover from other sources.

(2) Accuracy of default estimations (we are dealing with multiple future assumptions, after all) ?

(2) Danger of slippage from the equilibrium point: Q: Might an adverse Altman Z score accelerate the
date of default?

•  Suitability for consideration for your company?

Theoretically useful, but is its best application restricted to assessment of incremental

debt additions, and then only for firms already well below their D/C ceilings? 10
6 SPREAD ARBITRAGE, EQUITY v. DEBT RELATIONSHIP

•  Similar in some ways to No. 2 (always pursue cheapest source) BUT

Ø  Depends on advance development of reliable statistical model of ‘normal’

relationship between cost of major debt and major equity financial instruments–
e.g., the difference between five year term (that is, non-seasonal) loan to high
creditworthy company and equity

Ø  Financial management then acts on that difference, choosing the relatively less
expensive financing alternative when funds are required

•  Issues include:

(1) Development of requisite statistical analysis, unanticipated aberrations from established

patterns

(2) Reactive, as described here

(3) While possibly a suitable approach in terms of the AMOUNT of financing, may
nonetheless result in chronic under- or over-gearing depending on the timing of financing
actions.
11
.
7 SERVICING OF LONG-TERM DEBT

•  Refer to TIE (Times Interest Earned), CADS (Cash Available for Debt Servicing) in books,
Caution: www.investopedia.com definitions, equations may from time to time differs slightly from
what is in financial texts.

•  As applied, 1: Look at coverage rations of the subject company over a period of time (both
for purposes of assessing adequacy and to discern patterns of deterioration or conversely,
improvement

•  As applied, 2: Comparison to levels, patterns of same-industry competitors, other

reference points

•  Issues:
Problems in dealing with maturities’ spikes and deferrals. external changes in conditions that
render historical ‘safe’ coverage ratios obsolete. Time frame: What if the analysis is one year and
Titanic’s ice berg is year 3 and cannot be refinanced? To be complete requires trade-off analysis
with cost of one-step downgrade in credit rating. Q: When might a A- rating be preferable to A?

•  Suitability for your corporation?

Standard analyses that represent the starting point of any capital structure analysis.
Strategic CS insight from such analyses along probably limited. 12
8 SELECTIVE STAND-BY, NON-CANCELLABLE CREDIT FACILITIES

•  Use of a commitment to be able to obtain debt at the borrower’s discretion and timing (a call) in
place of actually adding that debt to the balance sheet.

•  Advantages: In gearing terms, company’s balance sheet appears better than it would
otherwise, unless company also has a future obligation to draw down those fees. Many
analysts, credit-rating agencies tend to positively figure in such stand-bys in accessing the
company.

•  Disadvantages: Reduced period income (annual commitment fees). Difficult to negotiate with
lead syndicate: You can only get the commitment if the bankers think that it is just for window-
dressing and will never actually be used.

•  Issues:

Tends to be limited to extremely large companies with high ongoing financing requirements: the
commitment is seen by the bank as a cost of securing fee-earning primary role with that desired bank.
The recent GM ($ 3Bn.) experience may have spoilt widespread use of this role.

•  Suitability for company?

Provocative, if the company qualifies and fee-eager bankers are willing to take the chance. 13
9 RELATIVE COST OF DEBT AND EQUITY AT DIFFERENT
EXTREMES OF BUSINESS CYCLE
•  Immediately after a recession (e.g. 1982, 1993, 2010), demand is down, the preceding
bubble has collapsed and debt tends to be cheap and equity dear. WHY? AND WHAT
EXPLAINS BOTH HIGH DEBT AND HIGH EQUITY DEMAND AT THE PRESENT TIME?

•  At the other extreme, escalating price-to-earnings multiple (P/E) indicate very, very cheap
equity for market leaders, just before the crash: GM (1929), Time Warner (1999), Amazon
(2000), Merrill Lynch (2007) WHY?

•  Issues:

OK, but who (besides Clark) has a business cycle crystal ball (sic). And what if my company
cannot wait until the theoretical ideal time. And if everyone things that way, doesn’t that diminish
any rate advantage?

•  Suitability for company?

Makes sense, IF (1) the company’s current and projected financing requirements are modest
enough that the company can wait for the right time and (2) when it comes to equity, if the
company is one of those that tends to be ‘bid up’ in the final stage of a expansion period
(business cycle). 14
 10 BASED ON COMPANY’S PRESENT STAGE IN ITS ECONOMIC LIFESPAN

Failing
High Innovation Fading Economic Returns Mature
Business Model

CFROI
? WHERE IS YOUR COMPANY IN
ITS LIFESPAN?HOW QUICKLY S
? IT DETERIORATING TO THE
NEXT STAGE?

WACC

? ?
0%

time from company origin (years)

Investmnt Maximum: Selective: Distribution, Patchwork: Selective i to Net Dis-

Capturing Share Building Demand lowing the Decline invesment
Gearing ~ 0% Up to 80% percent (peak) 60-70% (lag) - 40%, declining

Mode Expansion Consolidating Role as Holding on The end is near

Explosion Segment Leader

*CFROI (Cash Flow Return on Investment). Source Chart: Madden, 2005, 7. 15

11 RESERVE FOR CONTINGENCIES

•  Factoring in an extra cushion for errors– we are dealing with the future, after all

•  Either deliberate ‘safety’ margin and/or Expected Economic Return (EER) technique:
scenarios x analysed, estimated probabilities

12 IMMINENT OUTLAYS

•  Special provision for major expenditures known to be required over the next 1-3 years.

•  Not an ideal approach as it risks subjecting the OCS strategy to short-term abrupt swings in
investment approaches, possibly wasting expenditures.

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Number OCS Financing Mix Number OCS Financing Mix
Name Strategy Implic. Name Strategy Implic.
1. Target Adjust-ments Usually, 7. Debt D-E adj in accordance Depends whether
Gearing to LTD/C additions to E Servicing w/ TIE, CADS firm under- or
objective or E-for-D Cover over-leveraged
swaps
8. Non- Future bet: Small fee Limited
2. Pecking Lowest Cheapest debt, cancellable now to ensure access application, no
Order analysed AT at least ‘til end stand-by funds immediately
(Cheapest source facility
avail)
9. Oppor- Presumes typical Stockpiling funds
3. Funds Fastest Most expensive tunistic, on cycle, must know when that type is
Availability Cash: Need ST debt, often point in when debt and equity especially cheap:
(Speed) NOW w/ equity business each are cheapest D/C, cash
kickers cycle irrelevant
4. Lowest cost First, Equity 10. Based on Which of 4 life stages? Taking what the
Leveraging E, then gear (timing), Next, firm’s stage in How fast is the next market offers at
up New up like Pecking Co. Value coming? that life stage
Equity Order Lifespan
5. Static Brinkmanship Pecking order 11. Reserve Erring on side of Target gearing,
Trade-Off : high debt v adj. for for contin- conservatism, debt- but more cash & E
default amounts, but gencies wise
stop at signal
6. Spread Establish Incremental adj 12. Imminent Special arrangements Risks short-
Arbitrage D ‘normal’ to target outlays for specific large termism, high cost
vE relationship, gearing once project financings 17
return to that achieved?